16. Bad economics

The success of bad theory – neoclassical economics

This chapter has some technical material in it which may be unfamiliar to some readers. Please stick with it, to get the general sense of the arguments, because it is important to understanding the poor bases on which most current economic policy is made.

Neoclassical economics developed in the late 19th and early 20th centuries. In essence, it abandoned the theory of “intrinsic value” of the classical economists such as Adam Smith and Karl Marx in favour of “customer utility” (derived mainly from Jeremy Bentham). In other words, the price a customer was prepared to pay became the real determinant of the value of a product, rather than its actual cost. And this shift led them – and the economic world – in some strange and wondrous directions.

I had my first close encounter with the bizarre world of neoclassical economics when studying Stage One Economics for my Diploma of Accounting in 1979. Having enjoyed the elegance of the theory of supply and demand (a cornerstone of neoclassical economics), I was becoming concerned about how applicable it might be in the real world. The theory basically says that the prices of things being sold will naturally move towards an equilibrium point where supply equals demand.

My growing concern was how relevant this was to the real world, where corporate control over what is produced and how it is priced, and the influence exerted through advertising, seemed so much more powerful than anything a consumer brought to the market.

When I asked our very learned tutor about the problem I was having, his reply was “supply and demand works in vegetable markets in Africa”. And it probably does, in the smaller ones at least. I was pretty sure, however, that this wasn’t very useful in relation to larger and more sophisticated markets.

Then Kathleen Gallagher – at that stage a fellow student, even further out of her natural comfort zone than I was – referred me to one of the optional texts for the course, by Edward Wheelwright and someone else, I think. This suggested that neoclassical economics had serious methodological problems, it wasn’t the only gospel, and that a number of alternative ways of looking at economics were possible.

I give our lecturers credit, both for including the optional text in the course-work, and also for then allowing us to open up a debate in class about whether we should be being taught different economic approaches in a world where it appeared there were contestable models. Most of our fellow students were unimpressed with our concerns – they wanted to finish the course, put the right answers in their exam papers, and get their degrees. And so we had the debate, and nothing changed.

But as I learned more, neoclassical economics seemed more and more remote from something useful. The theory of the firm bore no apparent relationship to how businesses actually operate. The theory of trade (“comparative advantage”) simply ignored the reality of international power and politics.

And when economists were challenged for using unworldly assumptions and propositions, their response was that the ultimate test of the assumptions is the ability of the derived propositions to predict. This was clearly both self-serving and specious[i]. This sort of logic leads to propositions such as “milk should be forbidden, because 99% of heroin users started on milk”. And moreover, their systems were generally very poor at predicting real events anyway.

I discussed some of this with a prominent economist during my stint at the New Zealand central bank, and he agreed that a number of the basic postulates of neoclassical economics were flawed at best, and wrong at worst. But, he said, “It’s the best we’ve got, so we’ve got to keep working with it”. What? Surely, I thought, isn’t the answer to go looking for a better foundation?

A little earlier than this, I had been working for the Auditor-General on a housing issue. We were shown papers on housing policy, one from a long-term housing specialist, raising issues of supply, sufficiency, and social impacts. And one from the Treasury, which put all its effort into talking about how the offence that Mr Pink’s pink-painted house gave to Mr White would be resolved by the workings of the invisible hand of the market (hallelujah). In neoclassical economics terms, this was an exposition of the theory of rational choice. In real world terms, it was simplistic nonsense. But this was apparently how policy decisions were being made.

This was reinforced for me at the central bank, in a situation which had nothing theoretical about it at all. We had been looking at the cost of producing banknotes, and found through a “shadow tender” process that the Bank could save about $3 million, or 5% of its operating budget, by taking its printing offshore. This would cost 200 jobs in the northern New Zealand town of Whangarei, as the specialist printing factory there would have to close down. When we approached the Treasury and asked for some sort of calculus for this (how do we compare the benefit to the Bank with the social and economic costs of job losses?) they just looked at us blankly. The modern Treasury was filled with doctrinaire neoclassical economists, and the question had no meaning to them.

And a few years ago, I came across the “General Theory of Second Best[ii]”. This theory, which remains unchallenged, states that if any one of the conditions for perfect competition is violated, then all bets are off. In other words, more competition is NOT intrinsically better than less competition, unless it is perfect competition (impossible), based on perfect information (also impossible).

Neoclassical economics does most of its theorising based on perfect competition and perfect information, and holds it up as the ideal we should strive towards. The General Theory of Second Best says there is no point in striving towards it. We are either there (which is impossible) or we aren’t. And as it is impossible for us to get there, decisions on the balance of market to non-market interventions need to be made on a case-by-case basis, not by appealing to an abstract model of an ideal economy.

Which, unfortunately, is exactly how neoclassical economics works, and influences policy-makers. Here’s a little story about how it works.

Steve Keen on the failures of neoclassical economics

A few years ago I came across articles by Steve Keen, an Australian economist who thinks neoclassical economics is nonsense. The first article of his I read contained an explanation of how the Global Financial Crisis of 2008 had happened. Mainstream economists had famously failed to predict it, and their subsequent explanations looked a bit esoteric to me. My own understanding had been fairly simple – that (mainly American) banks had lent too much to people who couldn’t afford to pay to buy houses, and then repackaged and leveraged those loans into new packages and on-sold them as low-risk investments rather than the junk they actually were. And eventually the chickens came home to roost.

Keen’s article talked about “Minsky Models”, complex systems, dynamics, and how debt was critical to understanding the instability and regular collapses of capitalist economic systems. It made a lot of sense to me, once I got past the hard bits! And, it confirmed my own prior understanding.

I read his subsequent articles with great pleasure, and learned a lot. Eventually, I steeled myself to read his full text on neoclassical economics, “Debunking Economics”. I confess I skimmed some of the harder bits, and still don’t understand some of the underlying logic, but I understood enough to realise that my instincts had been right, and neoclassical economics is actually the economists’ equivalent of the conservatives’ “bullshit mountain” (thank you Jon Stewart)[iii].

Here’s my personal digest of the key points of Keen’s book:

The basic postulates of neoclassical economics contain demonstrable, and often proven, logical flaws (which means that, if economics were a science, they would be abandoned).

The assumptions underlying these postulates are very limited and unworldly (which means that they are unlikely to be useful in describing the real world, so should be abandoned).

And the way they are aggregated to form pictures of markets and economies is by simple accumulation, using static and linear modelling (which means that they ignore the complexity of markets – their ongoing change and development, and the emergence of new phenomena – so should be abandoned).

The key central tenet, that markets tend towards equilibrium (ie, in essence they are self-correcting), is nonsense – as proven time and time again in the real world – so it should be abandoned.

You might very well think that I’m exaggerating some of this. I’m not. Here, from Keen’s book, and backed up by reference to a highly respected neoclassical economist, is how a neoclassical model of the economy works (leaving out the more complicated bits, which just make it even crazier):

“This resulted in a model of the macroeconomy as consisting of a single consumer, who lives for ever, consuming the output of the economy, which is a single good produced in a single firm, which he owns and in which he is the only employee, …he decides how much labor to supply by solving a utility function … over an infinite time horizon, which he rationally expects and therefore correctly predicts. The economy would always be in equilibrium except for the impact of unexpected ‘technology shocks’ that change the firm’s productive capabilities … and thus temporarily cause the single capitalist/worker/consumer to alter his working hours. Any reduction in working hours is a voluntary act, so the representative agent is never involuntarily unemployed, he’s just taking more leisure. And there are no banks, no debt, and indeed no money in this model.”

No wonder these people failed to predict the Global Financial Crisis! Of course a market of this type might tend to equilibrium – if it existed, in some parallel universe. There has been some work in the mainstream post-GFC to try and improve things, for example using agency-based and network modelling, but I’m not holding my breath while they improve, because it is all still coming from fundamentally unsound premises.

In neoclassical economics, an economic system is simply the sum of the producers and consumers in it. This type of thinking led to the infamous Thatcherism, “There is no such thing as society”. Unfortunately, such a model has no predictive value for the real economy in the real world, as for example the Global Financial Crisis has shown. Economies are complex systems which need complex modelling, not static models which are based on ludicrously unrealistic assumptions and have no predictive power.

Despite its claims, neoclassical economics is not scientific – it is not a science. Its failures are deeply embedded in its underlying assumptions and “logic”. One of its most ludicrous basic tenets is that money is irrelevant to the behaviour of the “real” economy (ie the actual production and distribution of goods and service – clearly money is not irrelevant to this). And one of its most ludicrous predictions is that crashes and depressions won’t happen in the absence of “exogenous” (ie external) shocks (clearly they do, and with great regularity).

If neoclassical economics is not a science, what is it?

The values system of neoclassical economics

When we were being taught neoclassical economics, the lecturers told us, quite straight-facedly, that it was “value-free”. Apparently we were being offered scientific truth, on a par with, say, geometric axioms.

In a strange sense, they may have been right – for most of neoclassical economics, if you could create the required conditions, you might well be able to replicate the predicted results. Unfortunately, the required conditions rarely have any relationship to the real world or, if they do, are so restricted that they only apply in very narrow situations.

When we probed further, it appeared that “value-free” really meant “as compared with ‘ideological’ Marxist economics”. This was at best ignorance, and at worst downright propaganda. The ignorance could come from one of only two sources – the lack of an adequate philosophical base to understand that nothing is truly value-free, or the lack of sufficient understanding of the actual values underlying neoclassical economics.

The actual values are nicely hinted at in Keen’s description of a neoclassical macroeconomic model above. I describe them as “social Darwinism” – the misguided idea that society doesn’t exist, and that humanity is simply an accumulation of individuals whose only way forward is to compete with each other. The moral basis for this system is individual greed. In this world, “the fittest survive” and so “the devil can take the hindmost”.

There is inherent appeal in the idea that you are the chosen ones (the survivors, the foremost). But, of course this involves a complete denial of the trust, cooperation, and forbearance which underlies virtually all truly effective human enterprise.

Neoclassical economics is not a science, it’s a religion, but it’s a religion for the wealthy. Its tenets and its analysis inexorably lead to the concentration of wealth.

By assuming that consumers have equal power to producers (well actually, in the models, that they are the producers of their own consumables), and by ignoring government, neoclassical economics creates a playing field firmly controlled by corporate power. By ignoring capital and wealth and focussing only on production and consumption, it hides the impact wealth has on production and social outcomes (it is ironic that the economic theory underpinning modern capitalism has no theory of capital itself).

And by failing to grasp the complex and unstable nature of capitalist economies, it can neither foresee nor effectively respond to recessions and depressions, which cause far greater relative loss of wealth and income for the poor than for the wealthy.

This is the system of economic analysis which has driven most economic policy making (in the affluent world at least) over much of the last 100 years. And particularly the last 40 years or so, when its extension, neoliberal economics, has compounded its effects by postulating that markets make governments by and large unnecessary.

One of the reasons it has been so successful is that its basic axioms and ideas are superficially attractive. This is because they appear to have some relevance to how we as individuals act and think. And they probably do work quite well, in very small, isolated markets.

But our world is no longer made up of small, isolated markets. It is complex, it is interconnected, and humans no longer have anywhere they can externalise their costs to. Our economic assumptions and analysis need to take these things into account.

This chapter ends our quick tour of the historical developments underpinning our current situation: the Western “enlightenment”, the rise of mercantilism and capitalism, the rise of the United States, and the development of neoclassical economics.

The next three chapters look at the “engines” these developments created: modern capitalism, as such; the modern corporation; and the current financial system.

[iii] Jon Stewart, the great “Daily Show” satirist for many years, coined this term primarily in reference to Fox News and its appalling pattern of lies, but has used it subsequently to describe the conservatives’ beliefs and positions more generally